THE DAILY EDGE (2 October 2017)

The Fed’s preferred price gauge, the personal-consumption expenditures price index, rose 0.2% in August from a year earlier, the Commerce Department said Friday. Excluding volatile food and energy prices, the index rose a modest 0.1% on the month, less than economists had expected.

Compared with a year earlier, headline prices rose 1.4% and so-called core prices were up just 1.3%—well below the Fed’s long-elusive 2% annual target and showing little evidence of an incipient pickup. (…)

Another broad gauge of U.S. inflation, the Labor Department’s consumer-price index, showed stronger growth for headline and core prices in August. That was in part due to a jump in shelter costs; the Fed-favored PCE index gives significantly less weight to housing than does the CPI. (…)

Personal-consumption expenditures, a broad measure of household outlays on everything from groceries to doctor visits, rose a seasonally adjusted 0.1% in August from a month earlier.

Personal income from sources like paychecks, investments and government benefits was up 0.2% in August.

Adjusted for inflation, consumer spending fell 0.1% in August from the prior month. That was the first decline in price-adjusted outlays since January, driven in part by weak auto sales. (…)

This is the first important chart. Since March 2016, real consumer expenditures have grown 3.9% while real disposable income advanced only 1.7%. The resulting low savings rate has really happened once in the last 60 years (the U.S. housing bubble when Americans mortgaged their “ever-appreciating house” to buy cars, RVs, boats, etc.).

Which means that the odds are high that consumers will eventually want to restore their savings (or reduce their debt). If restraint happens during the coming spending season (Thanksgiving and Christmas), the economy will flirt with recession.

The problem is that not much is happening on the income side. Nominal disposable income is up 2.7% YoY in August but only +1.2% annualized in the last 3 months. The Fed wants higher inflation but slow inflation is currently saving the economy. If the PCE deflator was +2.0% annualized rather than its current +1.2%, real expenditures would be flat rather than rising at the +1.0% annualized rate recorded since May.

And we should not blame Harvey which hit August 25 and likely boosted consumption of essential items such as food and home protection stuff the week before.

Employment growth has slowed to +1.4% YoY but full-time employment growth was only +1.16% in August, from +2.27% last April and +1.9% on average in 2016. These are no minor declines when real consumer expenditures, 70% of the economy and the major contributor to GDP growth in recent years, are already near stagnation. Just as the main sources of income (employment and wages) are slowing near zero real growth, historically low savings offer no buffer to the economy.

Nearly half of Americans have a tough time paying their bills, and over one-third have faced hardships such as running out of food, not being able to afford a place to live, or not having enough money to pay for medical treatment. (…)

(…) What might be driving the optimism? One possibility is that economic improvement overseas might begin to bolster growth here. Another is that the Trump administration’s lighter touch on regulation could boost economic performance. Then, there is enthusiasm over some sort of tax overhaul getting passed and stimulating growth. (…)

Yellen last week:

How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments,” Ms. Yellen told a National Association for Business Economics conference in Cleveland. “It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.”

Ray Dalio last week:

It’s very important that the Federal Reserve be very cautious and slow to tighten monetary and fiscal policy because we have asymmetrical risks: many more risks on the downside than on the upside. (…) Even though the stock market is at its peak and the unemployment rate is at a low, for the bottom 60% it’s a bad economy. We must not have an economic downturn.

So, this may be early but nonetheless very à propos: Happy Thanksgiving and Merry Christmas!

Manufacturing operating conditions in China continued to improve at the end of the third quarter, albeit only marginally. Production and new orders both expanded at softer rates, with firms also signalling slower growth in export sales. As a result, purchasing activity increased at a weaker pace while staffing levels continued on a downward trend. Environmental inspection policies meanwhile weighed on supplier performance, with delivery times lengthening to the greatest extent since January. At the same time, inflationary pressures picked up, with average input costs and output prices both rising sharply.

The seasonally adjusted Purchasing Managers’ Index™ (PMI™) fell from 51.6 in August to 51.0 in September, but remained above the crucial no-change 50.0 mark for the fourth month in a row. That said, the index was consistent with only a marginal improvement in the health of China’s manufacturing sector.

The decline in the headline index coincided with a weaker expansion in total new business during September. Furthermore, latest data pointed to the slowest increase in new orders for three months. While some panellists commented that improved market conditions had helped to lift sales, other firms mentioned that subdued client demand had weighed on growth. Notably, new export work increased only marginally during the latest survey period.

In line with the trend for new orders, growth in output was the least marked since June and moderate overall. Purchasing activity also increased at a weaker pace at the end of the third quarter. (…)

Latest data signalled a sharp and accelerated rise in average cost burdens. Furthermore, the rate of inflation was the steepest seen for nine months, with a number of panellists linking inflation to greater raw material costs. As a result, factory gate charges rose at a faster pace.

About 40% of Chinese exports are to the U.S. and Europe where real domestic demand is growing 2.4% and 1.9% YoY respectively and threatens to slow even more. Note that Europe’s headline inflation rate was unchanged at 1.5% in September. The core rate slowed to 1.1% from 1.2%. Certainly not indicative of increasing demand.

China Throws Its Sinking Private Sector a Life Vest Private capital in China is reeling from forced factory closures and higher borrowing costs. This weekend’s move by the central bank to boost small enterprise lending won’t do much to improve the mood among entrepreneurs.

A high-level document published last week by China’s cabinet emphasized that entrepreneurs are important contributors to growth—but also that they need to be more patriotic and approach their role with the mind-set of serving society. Little wonder private investment has been weak for years.

Two of Beijing’s recent campaigns are threatening to make matters even worse. Forced factory closures this year in the name of curbing “overcapacity” have fallen disproportionately on private firms, both in steel and aluminum. Plans to expand the campaign to other sectors mean the squeeze will intensify.

China’s high profile crackdown this spring on dodgy “wealth management products” peddled by banks has also probably had the perverse effect of raising borrowing costs for some cash-strapped private companies who have trouble accessing formal bank finance—unlike many well-connected state firms. As a result, reliance on even more expensive forms of lightly regulated nonbank finance—like so-called trust loans and bankers’ acceptances—rebounded sharply in the first half of 2017. (…)

Conditions in the euro area manufacturing sector strengthened to the greatest extent in over six-and-a-half years during September. At a 79-month high of 58.1, little-changed from the flash estimate of 58.2, the final IHS Markit Eurozone Manufacturing PMI® signalled expansion for the fifty-first month in a row.

The average reading over the third quarter (57.4) was the highest since the opening quarter of 2011. The upturn remained broad-based by nation, with all eight of the surveys comprising the euro area average reporting growth. Germany moved back to the top of the rankings – its PMI hit a 77-month high – while the Netherlands PMI scored a 79-monthrecord, in second position overall. Austria was again one of the strongest-performing nations, despite seeing growth ease to a four-month low. Mild accelerations saw the France PMI and Greece PMI reach their highest levels since April 2011 and June 2008 respectively. The rate of improvement was unchanged in Italy, picked up in Spain, but slowed in Ireland.

Eurozone manufacturing production expanded at the fastest pace in almost six-and-a-half years in September, underpinned by a strong and accelerated increase in new work received. Improving domestic market conditions combined with increased levels of new export* business were the main factors supporting the latest increase in new work. Although September saw the rate of expansion in new export orders moderate, it remained among the strongest witnessed over the past six-and-a-half years. (…)

Stronger growth of output and new orders tested capacity at eurozone manufacturers, leading to the steepest increase in backlogs of work for over 11 years. This in turn encouraged further job creation, with employment rising to the greatest extent since the eurozone series began in June 1997. (…)

All of the nations covered by the survey recorded steeper increases in input costs. Average selling prices rose for the twelfth month running and also at the fastest pace since April. (…)

EARNINGS WATCH

During the third quarter, analysts lowered earnings estimates for companies in the S&P 500 for the quarter. The Q3 bottom-up EPS estimate has dropped by 3.0% (to $32.83 from $33.86) during this period.

During the past year (four quarters), the average decline in the bottom-up EPS estimate during a quarter has been 2.8%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 4.2%. During the past 10 years (40 quarters), the average decline in the bottom-up EPS estimate during a quarter has been 6.0%. (Factset)

THE HOPE:

From the standpoint of the stock market, the key change would be a cut in the corporate maximum tax rate to 20% from 35%, which would give a significant jolt to after-tax profits. For the big-cap companies of the Standard & Poor’s 500 index—which reached another record high last week—RBC Capital Markets estimates that a drop to 20% from their average effective rate of 27% would add $10.50 per share to earnings. (The current consensus 2018 forecast is $145, according to Bloomberg.) That would be worth around 200 points (or about 8%) for the S&P 500, based on a forward price/earnings multiple of 19 times, says RBC. Small-caps in the Russell 2000 index, which tend to pay a higher effective tax rate and thus would benefit more from a tax cut, also ended the week at a fresh record high. (Barron’s)

U.S. economic growth is accelerating and continues to come in better than expected, a bracing factor for stocks, says Keith McCullough, CEO of Hedgeye Risk Management, an independent research firm. Moreover, the third quarter should prove to be another strong profits season, he adds. Earnings reporting begins in mid-October, and the consensus sees a 6% rise in S&P 500 earnings per share, but we’re guessing many companies will beat analysts’ estimates.

Hmmm…Real GDP grew 2.1% in the first half of 2017, after +2.2% in the second half on 2016. The Chicago Fed National Activity Index, a composite of 85 monthly indicators, turned negative in August when 50 of the 85 individual indicators made negative contributions to the CFNAI. The ECRI Weekly Leading Index has declined for 12 consecutive weeks and its Growth Indicator last week recorded its first negative reading since March 2016. The Citigroup Economic Surprise Index has been negative since April. And the Philly Fed Business Conditions Index, designed to track real business conditions at high frequency, sank since the end of June to its lowest level since 2012. Hedgeye Risk Management surely does not see things with the same eye.

History doesn’t always repeat itself, but it’s often instructive. In the final quarter of a year in which the market made highs in September—statistically the market’s worst-performing month—stocks have typically finished with flair.

Since 1928, there have been 29 Septembers in which the S&P 500 made a 12-month high. Following those 29 instances, the market rose over 80% of the time in the fourth quarter, averaging a 3.7% increase, says Doug Ramsey, chief investment officer of the Leuthold Group. Better still, 15 of those 29 September price highs were also accompanied by 12-month advance/decline line highs—as is the case now. Stocks increased an average 5.9% in the fourth quarter in those 15 instances. (…)

A fourth-quarter rally isn’t a lock, but absent a big change in economic and monetary conditions, the bear case isn’t strong.

Bear markets are generally caused by recessions. The evidence for that anytime soon is weak. We’re neither Pollyannas nor Cassandras. The bull will die, but probably not in the fourth quarter. The holiday season should be a good one for equity investors.

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